Market Sentiment May Be a Leading Economic Indicator

The Global Market Sentiment Indicator that our Global Multi Asset Group developed has demonstrated its potential to be a leading economic indicator and a useful tool for guiding asset allocation decisions.

In building the Sentiment Indicator, we looked at the price and risk levels of various asset classes, dating back to 1970. Specifically, our analysis measured how much investors have been rewarded for taking on incremental units of risk in every major asset class – fixed income, credit, and equity – in both developed and developing markets. A rising indicator suggests improving market sentiment and a greater willingness among investors to take on additional risks. Conversely, a declining indicator signals deteriorating sentiment and a lower appetite for risk.

Sentiment Indicator Is Highly Correlated with Other Economic Indicators

We also found the Global Market Sentiment Indicator is closely correlated with other indicators of the business cycle, such as industrial production and earnings momentum. But perhaps even more importantly, the measure of current sentiment often functions as a leading economic indicator, anticipating shifts in other metrics by as much as a few months. As an example of this, the changes in direction of the GMAG Global Market Sentiment Indicator have often led the Earnings Per Share Momentum Indicator by four months.

Sentiment Indicator Aligns with Economic Cycle

We also found the Global Market Sentiment Indicator is closely correlated to the four types of macroeconomic regimes, as sentiment proved to be:

Below average but improving during a recovery

Above average and improving during an expansion

Above average but deteriorating during a slowdown

Below average and deteriorating during a contraction

Our analysis did find short-term periods when the Global Market Sentiment Indicator meaningfully diverges from our Global Leading Economic Indicator. These divergences often occur in extreme periods of investor optimism or pessimism, such as the market exuberance from 2005-2006 before the Global Financial Crisis or the market fears of contagion risk during the European Debt Crisis of 2011-2012. But even these divergences – when the sentiment levels seem to be far out of synch with other economic data – can be an indication that the market is either overreacting to the current levels of risk or that positive trends have already been fully, and perhaps excessively, “priced in” to asset class valuations.

Asset Classes Perform as Expected in Each Market Sentiment Regime

The historical evidence also suggests various asset classes perform as one would expect in the various market sentiment regimes. In periods of recovery and expansion, investors are rewarded for the extra risks they assume with asset classes such as stocks and credit. In periods of slowdown and contraction, riskier assets underperform and investors are rewarded for their flight to safety with investments such as U.S. Treasuries.

Sentiment Indicator Highly Useful in Evaluating Emerging Markets

Finally, the benefits of examining the Global Market Sentiment Indicator can be considerable with emerging markets. While structural reforms in many of these markets have narrowed the divide between them and developed markets, there is still less economic data available for emerging markets that investors can use to identify the current regime. Investor confidence can have a considerable impact on asset flows into or out of these markets, so the Global Market Sentiment Indicator can be a highly useful measure for determining what the current appetite for risk is and whether investors will be rewarded – or not – for taking on the extra risks associated with emerging markets.

Our empirical analysis confirms that market sentiment can be used in conjunction with leading economic indicators to support the identification of macro regimes and guide asset allocation decisions accordingly. The analytical tools presented in this article have been an integral part of our investment process for several years, and we believe they provide complementary information to the business and credit cycle frameworks we have introduced in the past.

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